There is Nothing Gross About Profit

Part 7 of a Series on Benchmarking Setting a gross profit target — finding a pricing, staffing, operating expense and profit model that is SMART — is the key to all business success. (SMART is defined as specific, measurable, attainable, relevant and time-sensitive.) No one can tell you what to charge for your work or what markup to use.

Alan Hanbury |December 13, 2005

Part 7 of a Series on Benchmarking

Setting a gross profit target — finding a pricing, staffing, operating expense and profit model that is SMART — is the key to all business success.

(SMART is defined as specific, measurable, attainable, relevant and time-sensitive.) No one can tell you what to charge for your work or what markup to use. Every company is unique in cost structure, volume and production efficiency. Each has a unique set of circumstances that point to its gross profit needs and thus gross margin. I can only tell you what to throw into the mix, how to work the math, and what to expect as you run the numbers through the grinder.

The first step is to calculate the expenses of running the business that occur whether we do one job or 100. This fixed portion, also known as overhead, includes rents; utilities; insurance; telephone and other communications costs; owners' salaries; administrative, design and production salaries and their labor burden; equipment leases; depreciation; and advertising. Fixed expenses are predictable from history.

Variable costs, which ramp up as we do more work and ebb as we slow down, create some guesswork. These costs include sales commissions, gas and oil, vehicle repairs, small tools, workers' comp, office supplies and services, additional marketing, entertainment, and education and training. Predict cost changes using past years' expenses, inflation, local economic news, interest rate movements, stock market swings and major corporate layoffs or hires. Guess high for safety's sake.

As you grow, you will need to hire. Add these salaries and benefits into the mix before you implement them.

The second step is to determine profit goals for the firm and for owner's compensation. Start with minimum dollar amounts. Only after completing a reasonable assessment of volume potential should you convert your dollar goals into percentage of sales — remember, we can't eat percentages. The owner's compensation benchmark is 10 percent, with a business profit goal of 10 percent. (See "Overpaid? Sometimes Paid? Owed Pay?" June 2004.

The third step is pulling the rabbit out of the hat: predicting sales. Again, history is the best indicator, in this case the company history of sales per employee and produced volume per employee.

If you historically have around $250,000 in sales per employee, have never produced more than $300,000 per employee, can't hire field employees because of a labor pool shortage, and don't have a good stable of subs, how can you think your five-person team, with three in the field, can go from $1.2 million to $2 million in volume? Even if you could sell that much, you could never complete the work in that fiscal year and thus could not collect that revenue. To get to $2 million would require fine-tuning your system to increase production per field employee to $400,000, plus the hire of two more leads of similar skills and experience.

This is called the reality check on labor. In a good market, sales can easily outstrip ability to produce work in the same quality manner our clients expect. The tradeoff is usually poor customer relations, more warranty claims and reduced referrals. This is the start of the end of your company culture — and usually the end of whatever success preceded it!

Increasing sales requires more leads and better qualification skills, design solutions and closing skills. All of these come with a price tag, a learning curve and, for many of us, a dive into the unknown.

Sales support must ramp up before the sales come in. Do you have enough working capital to get the ball rolling? You may need computers, software and additional employees to do sales, design and estimating. They all need desks, phones, beepers and insurance. These costs of employment must be paid before the new employees can pay for themselves in gross profits.